In general, as interest rates are lowered, more people are able to borrow more money. The result is that consumers have more money to spend, causing the economy to grow and inflation to increase. The opposite holds true for rising interest rates. Which of the two - lower interest rates or higher interest rates - is better for business operations and why? Discuss.

6-1 Suppose interest rates on residential mortgages of equal risk are 5.5% in California and 7.0% in New York. Could this differential persist? What forces might tend to equalize rates? Would differentials in borrowing costs for businesses of equal risk located in California and New York be more or less likely to exist than differentials in residential mortgage rates? Would differentials in the cost of money for New York and California firms be more likely to exist if the firms being compared were very large or if they were very small? What are the implications of all of this with respect to nationwide branching?

6-2 Which fluctuate morelong-term or short-term interest rates? Why?

6-3 Suppose you believe that the economy is just entering a recession. Your firm must raise capital immediately, and debt will be used. Should you borrow on a long-term or a shortterm basis? Why?

6-4 YIELD CURVES Yields on U.S. Treasury securities were as follows:

Term Rate

6 months 5.1%

1 year 5.5

2 years 5.6

3 years 5.7

4 years 5.8

5 years 6.0

10 years 6.1

20 years 6.5

30 years 6.3

a. Plot a yield curve based on these data.

b. What type of yield curve is shown?

c. What information does this graph tell you?

d. Based on this yield curve, if you needed to borrow money for longer than 1 year, would it make sense for you to borrow short term and renew the loan or borrow long term? Explain.

6-5 REAL RISK-FREE RATE You read in The Wall Street Journal that 30-day T-bills are currently yielding 5 5%. Your brother-in-law, a broker at Safe and Sound Securities, has given you the following estimates of current interest rate premiums:

Inflation premium= 3 25%

Liquidity premium = 0 6%

Maturity risk premium = 1 8%

Default risk premium = 2 15%

On the basis of these data, what is the real risk-free rate of return?

6-6 MATURITY RISK PREMIUM The real risk-free rate is 3%, and inflation is expected to be 3% for the next 2 years. A 2-year Treasury security yields 6 2%. What is the maturity risk premium for the 2-year security?